Chapter 12: Market Microstructure and Strategies

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Chapter 12: Market Microstructure and Strategies

Chapter Outline:

• Market Microstructure

• Stock Market Transactions.

• How Trades Are Executed.

• Regulations of Stock Trading.

• International Stock Trading.

Market Microstructure

• Market Microstructure is the process by which securities such as stocks are traded.

• For a stock market to function properly, a structure is needed to:

1. Facilitate the placing of orders.

2. Speed the execution of the trades ordered.

3. Provide equal access to information for all investors.

Market Microstructure

• What is market microstructure?– Study of the process and outcomes of exchanging

assets under explicit trading rules– Analysis of how specific trading mechanisms affect

the price formation process. Trading mechanism: set of rules governing the exchange of

financial assets (stocks, derivatives) or foreign currencies in a market.

⇒ specific intermediary, centralized location or electronic board, orders submitted,...

Market Microstructure

• Why do we need market microstructure?

Tries to answer how prices are formed in the economy!!!!

– Two different lines of thought in the past:

1. The trading mechanism has no relevance at all for the determination of the equilibrium price (Rational Expectation Literature),

2. The trading mechanism is relevant (Walrasian Auctioneer).

Organization of Financial Markets

• Market player– Brokers: transmit orders for customers, act as

conduits for the customers’ orders. Involved only in interdealer transactions (FX market) = pure match ⇒makers (connect dealers).

– Dealers: trade for their own account or also facilitate customer orders (broker/dealer).

– Market makers: (specialists): quote price to buy or sell. Generally take a position in the security = ⇒dealer function.

Organization of Financial Markets

• Orders:– Orders are instructions that traders give to the brokers and

exchanges that arrange their trades.

– They specify:• security to be traded,

• how much to trade,

• whether to buy or sell,

• Terms

– They may also specify:• their validity

• their execution time

• whether they can be partially filled or not

– Orders affect the profit from trading, transaction costs, and the liquidity.

Stock Market Transactions

• Placing an Order.

• Margin Trading.

• Short Selling.

• Investing in Stock Indexes.

STOCK BROKERS

• Full service brokerage firm– Assigned broker - personalized service

– Gives investment advice (research reports)

– Executes orders

• Discount broker– Executes orders

– Lower commissions

– Some advise (research reports)

STOCK BROKERS

• Brokerage Accounts:– Cash account

• Pay full cost of all securities purchased

• 2 business day settlement

– Margin account• Finance portion of purchases (interest charges)

• Same day settlement

MARKET TRADING DYNAMICS

• Market Order:– Buy or sell at the best current price

– Settlement in three business days

– Round lot = 100 shares

• Limit Order:– Puts a limit on price

– Time period can vary: day, GTC

• Stop Order:– Becomes order if price reaches specified price

– No guarantee of execution at specified price

MARKET TRADING DYNAMICS

• Long Position– Expectation - market heading higher

– Purchase stock via market order at the Ask

– Purchase stock via limit order at specified price

• Selling Short– Expectation - market heading lower

– Stock borrowed from broker

– Profits on drop in prices

– NYSE uptick rule discontinued

Margin Trading

• Margin Requirements.

• Maintenance Margin.

• Margin Calls.

• Impact on Losses and Returns.

Short Selling

• What is a short Selling?

• How speculators make profits in short selling?

• Measuring the Short Position of a Stock.

• Using a stop-Buy Order to Offset Short Selling.

Investing in Stock Indexes

• What is Stock Indexes?

• Why investing in Stock Indexes became very poplar?

• Exchange Traded Funds (ETFs), are funds that are designed to mimic particular stock indexes and are traded on a stock exchange.

Investing in Stock Indexes

Comparison of ETFs with Mutual Funds:• Similarities:

1. Adjustment of stock price.

2. Payment of dividends.

3. Lower management fees.

Investing in Stock Indexes

Comparison of ETFs with Mutual Funds:

• Differences:

1. Traded throughout the day.

2. Purchased on margin.

3. Can be sold short.

Investing in Stock Indexes

Types of ETFs:

• Cube.

• Spider.

• Sector Spider

• Diamond.

How Trades Are Executed.

• Floor Brokers.

• Specialists.

• Making a Market.

• Market Makers on the NASDAQ.

How Trades Are Executed.

Effect of the Spread on Transaction Costs:

1. Order Cost.

2. Inventory Cost.

3. Competition.

4. Volume.

5. Risk.

Electric Communication Network (ECNs)

• What is ECNs?

• Program Trading:

• Impact of Program Trading on Stock Volatility:

• Collars Applied to Program Trading:

Regulations of Stock Trading

• Circuit Breakers:

• Trading Halts:

• SEC Oversight of Corporate Disclosure:

Fair Disclosure (FD).

Barriers to International Stock Trading

• Transaction Costs:

• Information Costs:

• Exchange Rate Costs:

End of Chapter 12